THE BLOG

Startup Franchise Brands: Inadequate Disclosure and Irrational Decisions

01/22/2014 12:05 EST | Updated 03/24/2014 05:59 EDT

Increasingly, individual Canadians commit their life savings to become franchisee owner/operators of franchised stores. On the franchisor side, a growing segment of the Canadian franchise industry is made up of risky startup brands. Startup franchisors, owners of these newly founded franchise brands, seem to spring up from the ground like mushrooms after the rain.

Not all startup franchisors are without merit. Some are based on solid financial footing, offer a unique, considered and competitive concept, are run by experienced management, and provide adequate franchisee support. Yet many other startup franchisors do not offer much by way of any of these elements.

Ironically, like many of their would-be franchisee store operators, such deficient startup brands are themselves owned and operated on a shoestring budget, with no professional management, no arm's length employees at all, or no employees with adequate business experience, no financial resources and no support infrastructure.

These are essentially inexperienced and unsophisticated entrepreneurs who are store operators, disguised as franchisor executives -- "mom and pop" stores that recast themselves as lofty, but hollow, franchise brands.

Surely some of the more established or large franchisors in Canada have their own significant business and legal challenges. But franchisees' challenges against those more established franchisors do not tend to result in complete business losses or store terminations or closures at the same alarming frequency as legal claims against startup franchisors.

It is perhaps a little known fact that many owner/operator franchisees in startup networks fail and end up in financial ruin when they shut down their stores within only a year or two of starting to operate, in the face of mounting and devastating financial losses.

This affects not only so-called "new Canadians", but also the middle class and people who leave corporate management jobs and, for a variety of personal reasons, try to pursue such a venture and fail.

At the core of the problem is the fact that most prospective franchisees are unaware, whether wilfully or not, of the heightened risks associated with investing in a startup franchise.

The reasons, I believe, are two-fold.

First, franchise disclosure documents of many startup franchisors offer little or next to no meaningful information that legally qualifies as "material fact" or "material changes" about the franchise system and the specific and genuine risks that are associated with the particular business that is being offered for sale.

Second, as suggested in behavioral economics, humans are known to make irrational investment or financial decisions, even when presented with the necessary information.

Ontario, Alberta, Manitoba, New Brunswick, and Prince Edward Island have franchise legislation (the remaining provinces should consider coming on board without delay, with British Columbia well underway). Contrary to the disclosure requirements in these franchise statues, the typical disclosure documents that startup franchisors tend to provide to prospective franchisees do not even come close to disclosing all "material facts"/"material changes" about their franchise systems and the franchised businesses being sold. (See, generally, Material Facts, Material Changes and Franchisor's Associates: A Disclosure Document Primer.)

In Ontario (and to a great extent in the other provinces that have franchise and securities legislation), there is a striking resemblance between the "material fact"/"material change" requirements in the securities and franchise disclosure legislation.

Both legislative frameworks are designed to, in addition to other unrelated statutory purposes, protect investors - capital market investors and franchisee investors, respectively.

The meaning of "material fact" and "material change" under Ontario's Securities Act is practically the same as the meaning of these terms in the franchise context under Ontario's Arthur Wishart Act (Franchise Disclosure), 2000.

Despite this similarity, the quality of material facts/material changes contained in disclosure documents of securities issuers, and the quality of this type of information in disclosure documents of startup franchisors in Ontario are worlds apart.

Securities disclosure documents tend to provide a great deal of material facts/material change information with respect to their operations and the risk to investors, while startup franchisors provide little, if any (not including information that is specifically prescribed), such genuine material facts or material change information.

Provincial franchise statutes represent fundamental rights for franchisees. They entitle franchisees to a rescission remedy (meaning a complete legal cancellation of the franchise purchase) and full compensation if franchisors fail to provide them with full disclosure as required. In addition, the statutes provide a right to claim damages for breaches of other legal obligations, such as fair dealings and the right to associate.

Even though the legal rescission remedy for failure to provide full franchise disclosure to prospective franchisees is dramatic, many franchisees do not pursue these rights.

There are many reasons for this phenomenon: some have to do with barriers to access to justice; others have to do with the complexity of franchisees' typical problems in relation to their abilities to handle them (see Franchisees Closing Down: Problems With Getting Help); yet others likely have to do with irrational human behaviour.

Prospective franchisees share the blame.

Here, too, I borrow from the securities field by analogy, which offers a developed research and commentary on an apparently similar problem.

No matter the level of disclosure, it seems that many financial investors would nevertheless invest for often irrational reasons. (See Janis Sarra, "Modernizing Disclosure in Canadian Securities Law: An Assessment of Recent Developments in Canada and Selected Jurisdictions", "Canada Steps Up", Task Force to Modernize Securities Legislation in Canada, May 29, 2006.)

To the misinformed franchisee investor, the following reasons, offered by way of examples of irrational reasons, may be compelling to investing in a risky and deficient startup brand.

Often, startup franchisors provide better and direct access to the so-called "founders" of the franchise company, since they are typically run by only a handful of individuals. They offer more by way of "salesmanship" relationships with direct involvement of the franchisor owners, because they are eager to get established and expand, whereas established franchisors tend to have stricter controls and policies regarding the sale process, as well as designated in-house staff to handle this process. And startups tend to offer better territories or locals than established franchisors, which already have presence across a region, province or the country.

These reasons are in fact irrational because a store in a startup system requires the same (often even more) capital to set up and operate as a store in an equivalent but established system, while the former comes with a heightened risk of failure and a lower projected financial return.

More specifically: (i) there is a significantly higher risk to successfully operate a store in a startup network with no proven track record; (ii) any internal earning projections for a store in a startup network would naturally have to be much lower than a store in a more established system, and (iii) the purchase, setup and operational costs of a store in a startup system is generally equal to a similar store in an established system.

There are some meritorious startup systems with a promising future, based on their management, product offering, financial backing, and other key factors. But, subject to these and other factors, it is otherwise generally irrational to invest in a typical startup franchise brand, as opposed to an established one.

Separating and making sense of these factors is not easy for the average prospective franchisee.

Despite humans' behavioral shortcomings and tendencies to sometimes make irrational decisions, much can be done to better educate, inform, and where merited, warn, the public about investing in franchise systems that are not only untested but which pose a high risk of significant loss due to critical predictive factors, such as claims, losses, complaints, etc.

I again draw by way of an analogy from the securities field. The Ontario Securities Commission provides such information through, for example, Investor Warnings and a Warning List about possible harmful activity in progress, or unscrupulous individuals and companies that appear to engage in high risk activities. As well, it provides an Investor Education Fund, brochures, and many more tools and resources. The Canadian Securities Administrators maintains a Disciplined Persons database of disciplined individuals in provinces with securities legislation.

All Canadians have a stake in reducing franchisees' drastic losses in startup brands.

Franchising is an integral part of Canada's economy, particularly the retail sector. Canadian franchisee investors and consumers are drawn to franchise brands based on their potential to offer proven business systems, consistency and recognized goodwill. Canadian taxpayers indirectly fund a great portion of this retail segment of the economy through the federal government's Small Business Loan Program.

Professionals, industry, government and the public should help prospective franchisees become better informed and, where reasonably possible, help reduce individuals' inherent tendency to make irrational financial investment decisions in franchising.